Twitter shares four years from today — down 45%?

A gauge that tracks sales growth suggests there’s more pain ahead

Twitter and Facebook have taken a beating, with their shares down 45% and 19% from recent highs.

They could be in for more punishment.

That, at least, is the conclusion of a common valuation formula that uses projected sales growth to estimate where newly public stocks will be trading five years after their initial public offerings.

Focusing on sales is important because both Twitter
TWTR, -1.79%
and Facebook
FB, -1.82%
— like most young firms — are sacrificing earnings to invest in future growth. As a result, earnings-based valuation measures may paint a distorted picture.

The sales-based formula discussed here is based on two key assumptions: how fast a company’s revenue will grow over its first five years as a public company, and what its price/sales ratio will be. (The price/sales ratio is calculated by dividing stock price by sales per share.)

We know how fast sales have grown at newly public companies in the past because of research conducted by Jay Ritter, a finance professor at the University of Florida who studies IPOs, and two colleagues at the University of California, Davis — Martin Kenney and Donald Patton, a professor and research associate, respectively. They studied 1,700 U.S. companies whose stocks began trading between 1996 and 2007.

They found that these companies’ sales on average grew 212%, in inflation-adjusted terms, over their first five years. That is far faster than the growth experienced recently by companies overall. For the S&P 500, inflation-adjusted sales have actually fallen over the past five years.

What about the typical young company’s price/sales ratio? According to FactSet, the median ratio for stocks in the Dow Jones U.S. Internet Index on their fifth birthdays was 5.87. The current price/sales ratio for the S&P 500 is 1.64.

Using Ritter’s data, forecasting Twitter’s stock in November 2018 — five years after its IPO — becomes a matter of simple math: Multiply its sales per share in the 12 months before going public by 212%, and multiply that by the price/sales ratio of 5.87.

Those calculations suggest its stock will be 45% lower than where the messaging service trades today. That is above and beyond the loss the stock has already suffered. A Twitter spokesman declined to comment.

The picture at Facebook potential is even less pretty: The social network’s price in May 2017 — five years after its IPO — will be 50% lower than where it is today. A Facebook spokeswoman declined to comment.

How can Twitter and Facebook escape these awful fates? Either their sales will have to rise faster than average, or their price/sales ratio will have to be higher.

Either is certainly possible, of course. “For companies that operate in ‘winner take all’ markets, the profit potential is enormous,” Ritter says. “This is why Facebook was willing to pay $19 billion for WhatsApp,” referring to the smartphone-messaging app that Facebook acquired in February.

Ritter hastens to add, however, that the Achilles’ heel of these winner-take-all markets “is that a company’s niche can evaporate almost overnight.”

Investors willing to tolerate that risk may want to instead bet on high-tech companies with more reasonable valuations. Only three such stocks in the Dow Jones U.S. Internet Index are recommended currently by even two of the 42 advisers on the Hulbert Financial Digest’s monitored list who have beaten the Wilshire 5000 index over the past 15 years. (That is a long enough period to largely eliminate the role luck may otherwise play in a good track record.)

They are Google, operator of the world’s largest search engine; Yandex, its Russian counterpart; and Qihoo 360 Technology, the Chinese Internet company. When focusing on trailing 12-month sales, all three stocks trade at lower price/sales ratios than either Twitter’s (36.8, according to FactSet) or Facebook’s (19.7). Google’s is the lowest, at 3.1, Yandex’s is 7.6, and Qihoo’s is 11.

While these valuations may make these stocks less vulnerable than either Facebook or Twitter to a slowdown in sales growth, bear in mind that the Internet sector still is a lot more volatile than the overall stock market. The Dow Jones Internet Index has historically declined 23% further than the S&P 500 during broad market declines.

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